Dreams of a Market Downdraft Drifting in the Distance

The S&P 500 Index has ground to a halt at a resistance level. Here's where it's headed next.

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MINYANVILLE EXCLUSIVE: The coming weeks will be the most important for the stock market since the March 2009 bottom. For the past three years, we have lived in a world shaped and secured by accommodating Federal Reserve policies. Record low interest rates accompanied by the printing of trillions of dollars have kept the country from experiencing a credit flow cardiac arrest.

As Federal Reserve Board Chairman Ben Bernanke alluded to in late March, further quantitative easing would require a weakening economy or signs thereof. Almost as if scripted, we received a March non-farm payroll report that slipped and fell on its face, showing anything but a growing recovery.

Now, the S&P 500 Index (SPX) has ground to a halt at a resistance level of $1420-$1440. We are in the late innings of a bear market rally, and we have enjoyed the ride. Now it's our duty to decide: Do we take the money and walk, or should we stay and double down?

As far as where the markets are going, it is my belief that we will witness a blow-off soon. Spain, next of the PIGS on the chopping block, is one to be concerned with. Their debt burden is the size of a bazooka compared to Greece's six shooter. After that, Italy. Then we shall see which of the euro banks are left breathing.

About 84% of fund managers expect to be net buyers of stocks in the next six to 12 months, according to Barron's. I wonder how many of them felt this way in the face of a 20% correction last October when the market traded at a 10x multiple? To date, 70% of S&P 500 companies have beaten estimates in the current quarter, the most since the first quarter of 2006.

In fact, in 2006 after a productive earnings season, the market peaked in May, fell 5% into the summer, and didn't break even until October. This is a path many analysts are predicting for 2012.

The caveat to the current recovery is that every recession in modern history has been followed by rising interest rates, with the exception being this post-recession period. Interest rates can't rise, because the economy is too fragile and government debt too onerous, which means the economy is on shaky ground.

Meanwhile, the deflation dialogue is back in full swing. Witness Christine Lagarde's characterization of the recent light recovery as "blowing in a spring wind with dark clouds on the horizon." This rally has been driven by the creation of government debt and fueled by the expansion of money supply. All that may change. In a speech given yesterday, European Central Bank member and head of German Bundesbank Jans Weidmann stated simply, "Monetary policy is not a panacea and central bank firepower is not unlimited, especially not in a monetary union. We can only win back confidence if we bring down excessive deficits and boost competitiveness. It is precisely because these things are unpopular that makes it so tempting for politicians to rely instead on monetary accommodation. More of the same will not take us anywhere, the analgesic we administer comes with side effects. And the longer we apply it, the greater these side effects will be, and they will come back to haunt us in the future." Sound familiar?

I believe we are in the process of putting in a significant top, but the bulls are not finished, even though they are fearful. Per my last market overview (see Irrational Exuberance? Not Yet, but Working Our Way Toward It), we are short-term risk off, having lightened up on positions as we side stepped into my target on the SPX of $1420-$144. As of now, we are not net short the market.

The complexity of the market has increased and stocks are telling us this with their price action. It has been a terrific ride since stating my case for an outsized equity rally in late December (see Interview: What to Expect From the Markets In 2012). With the exception of select names, I am no longer looking to commit capital at these levels with an intermediate term horizon. Lower levels will provide such opportunity.

As tops take time to develop, look to re-position long holdings with a test into the 200-day exponential moving average, or SPX $1295-$1310, by the time we arrive. From there, we will gauge the potential of the market's next move higher and likely its last run. Where that ends, we shall see and we will be ready to allocate our capital accordingly.

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